Question

1. Anyidado Ltd. is considering a new project that complements its existing business. The machine required for the project costs GHS3.4 million. The marketing department predicts that sales related to the project will be GHS1.9 million per year for the next four years, after which the market will cease to exist. The machine will be depreciated down to zero over its four-year economic life using the straight-line method. Cost of goods sold and operating expenses related to the project are predicted to be 30 percent of sales. Anyidado Ltd. also needs to add net working capital of GHS250,000 immediately. The corporate tax rate is 35 percent.
New investment projects in Anyidado Ltd. have the same risk as the firm’s typical project. The has 8 million shares of common stock outstanding, 0.5 million shares of 6 percent preferred stock outstanding, and 100,000 9 percent semi-annual bonds outstanding, par value GHc1,000 each. The common stock currently sells for GHS 32 per share and has a beta of 1.15, the preferred stock currently sells for GHS 67 per share, and the bonds have 15 years to maturity and sell for 91 percent of par. The market risk premium is 10 percent, and T-bills are yielding 5 percent.
Required:
(a) What is the cost capital that should be used to assess the viability of the project?

(b) Using the NPV rule, should the project be accepted?    

Answer 1

a)

Cost of equity using CAPM = risk free premium + beta ( risk premium )

Cost of equity = 0.05 + 1.15 ( 0.1 )

Cost of equity = 0.165 or 16.5%

Cost of preferred shares = 6%

Coupon payment = 0.09 * 1000 = 90 / 2 = 45

Number of periods = 15 * 2 = 30

Price = 0.91 * 1000 = 910

Before tax cost of debt using financial calculator = 10.18%

Keys to use in a financial calculator: 2nd I/Y 2, FV 1000, PV -910, PMT 45, N 30, CPT I/Y

After tax cost of debt = 0.1018 ( 1 - 0.35 )

After tax cost of debt = 0.06617 or 6.617%

Market value of equity = 8,000,000 * 32 = 256,000,000

Market value of preferred stock = 500,000 * 67 = 33,500,000

Market vlaue of bonds = 100,000 * 910 = 91,000,000

total market value = 256,000,000 + 33,500,000 + 91,000,000 = 380,500,000

Weight of equity = 256,000,000 / 380,500,000 = 0.6728

Weight of preferred stock = 33,500,000 / 380,500,000 = 0.088

Weight of bonds = 91,000,000 / 380,500,000 = 0.2392

Weighted average cost of capital = weight of equity * cost of equity + weight of debt * cost of debt + weight of preferred shares * cost of preferred shares

Weighted average cost of capital = 0.6728 * 0.165 + 0.2392 * 0.06617 + 0.088 * 0.06

Weighted average cost of capital = 0.111012 + 0.015828 + 0.00528

Weighted average cost of capital = 0.1321 or 13.21%

Cost of capital that needs to be used is 13.21%

b)

Initial investment = cost of equipment + net working capital

Initial investment = 3,400,000 + 250,000 = 3,650,000

Annual depreciation = 3,400,000 / 4 = 850,000

Costs = 0.3 * 1,900,000 = 570,000

Operating cash flow from year 1 through year 4 = ( Sales - costs - depreciation )( 1 - tax ) + depreciation

Operating cash flow from year 1 through year 4 = ( 1,900,000 - 570,000 - 850,000)( 1 - 0.35 ) + 850,000

Operating cash flow from year 1 through year 4 = ( 480,000 ) ( 0.65 ) + 850,000

Operating cash flow from year 1 through year 4 = 1,162,000

Non operating year 4 cash flow = Net working capital = 250,000

NPV = Present value of cash inflows - present value of cash outflows

NPV = -3,650,000 + 1,162,000 / ( 1 + 0.1321)¹ + 1,162,000 / ( 1 + 0.1321)² + 1,162,000 / ( 1 + 0.1321)³ + 1,162,000 / ( 1 + 0.1321)⁴ + 250,000 / ( 1 + 0.1321)⁴

NPV = -56,496.1

Since it has a negative NPV, project should NOT be accepted.